Tax Tip 16: Capitalising Interest

Am new to loans & taxation, here's the scenario:

Partner and I moved out of our PPORs and now live together in rental property. We've since turned both our PPORs into IPs. My PPOR was unencumbered, partner's was P&I with100k outstanding. After they've become IPs, we did a loan restructure.

Mortgage broker did this:
Loan 1 - Equity release of $300k from my PPR now turned IP (I/O w 100% offset)
Loan 2 - Refinanced partner's 100k loan into an I/O fixed rate loan

Plan is to use the released equity to buy IP3.
Once bought, loan 1 is split to make things neat.

Settlement happened last week, the released equity is now sitting in the offset (which I'm aware I shouldn't mix with non-borrowed funds).
Broker set it up such that interest repayments for both loans is taken out of the offset account.

1. Is this strategy basically Interest Capitalisation?
2. Seeing that we now don't have any PPORs (no non-deductible debt), is this strategy okay or still considered risky?

 

Capitalising interest involved not paying the interest on the loan and allowing the balance to increase or borrowing to pay the interest.

Are you doing either of those?

 

The offset is filled with borrowed funds from the equity release, and those borrowed funds will be used to pay the monthly interest from both loans. So I'd consider this interest capitalisation, no?

Main question is the fact that we have no PPOR loans (everything is investment-related), so we're not doing this strategy to pay down non-deductible debt. Will this be okay with the ATO?

If this is still considered risky, then I'll use my own cash to pay the interest.

 

Yes this is capitalising interest.
It could be ok, but seek personal tax advice.

 

If this was considered ok. and you were just starting out and not planning on getting a ppor. would it be best to use this method of capitalising interest in the building of the portfolio stage? as the cash from rent would be in offset account on ip's. BUT when in a few years you did decide to buy a ppor the benefit would be much greater as you'd have more cash and less non deductible debt?

 

It would be hard to implement as how would you borrow to pay the interest?

 

you mean in the sense that your equity pulls will mostly be used to fund deposit's for the next purchases?

if the case maybe after you acquired your portfolio. then use excess equity to start interest capitalising strategy? I'm trying to see where it could be useful to implement

 

When starting out people don't have equity. Once they build some up they then have a choice of using it to pay for existing expense and/or to use for the next purchase.

once the PPOR loan begins going down it would be easier to do.

 

wouldn't this be a scheme as you'd have cash coming in from rent etc sitting in an account not being used but you'd be using equity to pay for interest? = main purpose tax deduction?
@Terry_w

 

Well, if there was no PPOR debt there is no current tax advantage to doing this. The tax advantage would come later perhaps - if a PPOR is purchased with the cash saved that, the cash that otherwise would have been used to pay the interest on the loan.

 

that makes sense, also i had a thought. the main reason for this strategy is cash flow changes could interest rate rises be a acceptable reason to capitalise interest? but then if u had a ppor the ato would think you'd have to capital interest interest on non deductible loan and deductible loans not just deductible loans?

 

That may be one reason worth exploring but I don't know whether it would be acceptable or not. You should consider applying for a private ruling.

 

I have to say, thank you so much @Terry_w for the wonderful insight you've provided - whenever I find myself with a question more often than not you've already answered it (sometimes quite a few times).

Would it be too simplistic to think of it this way?
- Tax deductible costs for the IP should be paid for with 'cash' (funds held in offset against PPOR ideally).
- Capitalisable costs for the IP should be paid for with a dedicated loan e.g. LOC (interest on this loan is then tax deductible).

Which leads me to wonder (assuming IP is 100% used for investment purposes):
1. Is there any kind of cost related to the IP which is both capitalisable & tax deductible?
1.a Would 'renovations' be classified this way, since depreciation can be claimed as a tax deduction and the cost of the renovation is added to the cost base?
1.b If that's right, would the interest paid on the loan for renovations be tax deductible?
2. Is there any kind of cost related to the IP paid for by the investor which is neither capitalisable nor tax-deductible?

 

Anything investment related and borrowed would mean the interest on that loan is deductible.

But there is the risk of the commissioner of the ATO denying the deduction of interest by applying Part IVA where it is a scheme with a dominant purpose to save tax. So you have to be careful in this regard.

Whenever you do something like capitalise interest you have to think of your reasoning. If you cannot afford to pay the interest then capitalising may not attract Part IVA. If the reason is to divert income to the paying down the non deductible main residence loan then this is beginning to look like a scheme.

The ATO are concerned about borrowing to pay expenses, but so far, as far as I know there is no ATO material which says they will deny the interest on these borrowings, even where it is a way to pay the home loan off sooner.

 

I suspect Mary will have a better chance of using this approach.

Mary receives rental income of $240k/year but her total expenses include $140k (P+I loan) and $50k of other property related expenses leaving her only $50k per annum to live off. Mary needs $80k per annum to pay her living expenses (all before tax) which include a rental PPOR.

Mary was previously making up the shortfall with a high-income job. But Mary recently resigned as she felt burnt out. Mary now plans to travel before starting a business of her own. She doesn't expect the business to make a profit for the first few years - if it succeeds at all. Mary has a lot of equity but has almost maxed out her borrowing capacity. She somehow obtains a loan (possibly a LOE) for $200k and Mary uses this money to pay a portion of her deductible expenses while capitalising the interest.

As soon as Mary is able to fund the shortfall in her living expenses from a different source (eg. business income or increased rents) she stops using the LOE to pay a portion of her deductible expenses.

Would Mary trigger Part IVA with this arrangement?

 

Because Mary has no other income the dominant purpose may not be for a tax benefit but for survival. She has a good chance of Part IVA not applying.

See also
Tax Tip 24: Capitalising Interest and Non working spouses https://propertychat.com.au/communi...lising-interest-and-non-working-spouses.3115/

 

Do you think paying down PPOR debt is the main problem? ie if you don't have and don't intend to have a PPOR, would this mean you have a high chance of being in the clear?

Also, how hard is it to get a private ruling? Is there a lot of work? or fees?

 

Depends on the situation.

Very easy to get a private ruling but harder to get one done properly so it covers all bases.

I charge $1100

 

Two taxpayers cannot each have a 100% main residence exemption.
There may be scope for absence BUT....A joint approach has to be taken. Spouse 1 will make a CGT election that affects spouse 2 and vice versa.

 

I agree with Terry. Merely arguing that one taxpayer needs to use borrowed funds while their partner produces cashflow that pays down non-deductible debt would be a material issue the ATO needs to consider in its ruling. I would think it could become time consuming and costly. Or a limited ruling.

The ATO likely would give a base ruling then add a proviso ....Subject to the taxpayer making full disclosure and that the taxpayers do not undertake a scheme to which Part IVA could apply...ie the ruling may be of limited value if your behaviour is one to which a scheme could be later determined to apply.

This is how so many rulings are worded eg hybrid trusts, borrowing schemes etc